Source: Deloitte’s Monday Briefing 9/02/15

Historically, big deficit reductions, such as the one being implemented by Greece, have occurred in times of deep economic crises. Yet the UK looks set for a period of sustained growth.

So why are mainstream politicians united in their commitment to squeeze public spending?

Britain may be on the mend but its public finances remain in poor shape. The IMF forecasts that the UK will have the largest underlying budget deficit, excluding the effects of the economic cycle, in Europe this year. On this measure Britain’s finances are in worse shape than those of Portugal, Italy, Ireland, Greece or Spain. Among the major developed nations only Japan is running a bigger deficit than the UK.

The financial crisis knocked a big hole in Britain’s public finances. Even without it, the rising costs of social support, healthcare and an ageing population, require a big adjustment in the public finances. To help provide the flexibility to cope with future economic shock, the UK needs to get public spending into line with revenues.

So far a yawning public sector deficit has not deterred investors from buying government debt. On the contrary, the price of UK government debt has soared to record levels. Talk of the UK losing its coveted triple A credit rating has all but disappeared.

The apparent indifference of markets to the scale of the UK deficit demonstrates that demand for bonds is not just about levels of public borrowing. Expectations of very low inflation and the perception of UK debt as a safe haven asset have helped buoy demand for UK government bonds.

Investor confidence is also underpinned by the Coalition’s aggressive deficit reduction programme. Since the financial crisis, the UK has effected the seventh-largest fiscal consolidation among 31 advanced economies tracked by the International Monetary Fund.

The success of this programme has, however, been blunted by a lopsided economic recovery, characterised by falling wages and lower-than expected tax revenues. Deficit reduction has been slower than expected, even though growth has been faster than forecast. According to the Institute for Fiscal Studies, the coalition have achieved just under half of the planned deficit reduction.

Current plans imply that the bulk of the remaining consolidation will to come in the next parliament, in the form of spending cuts. In its Green Budget released last week, the IFS estimated that this would amount to cutting public spending, as a share of national income, to its lowest level since at least 1948. These are big cuts with major implications for public sector employment and the quality of public services. The Office for Budget Responsibility estimates that it would result in 900,000 job losses in the public sector and reduce the size of the general government workforce to its lowest level since 1971.

Labour and the Conservatives may be united in their commitment to deficit reduction, but they differ significantly in their views of urgency of the task. The IFS’s estimates that to meet their fiscal targets the Conservatives would have to cut in real departmental spending by 6.7% between 2015 and 2019; Labour could hit its, less demanding rules, by cutting spending by 1.4%.

According to earlier calculations by the Financial Times, this would imply that, by 2019-20, Labour would be spending £27 billion a year more than the Conservatives – a very sizeable difference.

Clear blue water is opening up between the parties on public spending. The Conservatives will have to cut spending aggressively to achieve their target of balancing the budget. Labour offers less pain on public spending but a correspondingly higher level of borrowing – which could create greater future vulnerabilities.